Recent High Yield Dynamics

We have seen various market dynamics impact the high yield bond market and some selling pressure ensue over the past couple weeks; however, at the end of the day, we do not see that the opportunity in the high yield market has evaporated or that investors should run for the exits—if anything, lower prices can present a buying opportunity.  As an active manager, we have the ability to sell securities that have appreciated in value and/or sit at large premiums, and buy securities that have fallen in price during this widening; passive, index-based products are limited in their ability to do this.

In terms of some of the market impacts on high yield over the past couple weeks, one issue raised was Fed Chair Yellen recently expressing concerns on the valuations in the high yield market.  Of note, she also commented on over-valuations in biotech and social media stocks.  It seems a bit odd the Yellen is giving us investment advice, though nothing surprises us coming out of DC these days. I thought the Fed’s “statutory mandate” was “maximum employment, stable prices, and moderate long-term interest rates,” and then “explaining its monetary policy decisions to the public as clearly as possible”1?   We also saw James Bullard, President of the St. Louis Fed (though a non-voting member of the Fed), commenting that the Fed may need to raise rates more quickly than some have expected as the unemployment rate falls, inflation picks up, and macroeconomic conditions improve.

We think that investors need to keep these comments in perspective.  Yes, the high yield market has seen a large run up over the past several years and yields are low relative to history, but that is because interest rates have been at or near all-time lows for years (the Fed’s doing), pressuring yields in all fixed income securities as investors search for places to generate returns.  However, comparatively, we believe the high yield market, outside of the large flow names widely held by the index-based products, still looks very attractive.  Additionally we sit at a spread-to-worst level (the spread or yield-to-worst advantage over the yield on a comparable maturity risk free security/Treasury) of 428bps today, which is well over the all-time lows on spreads of 271bps, set in 2007 according to the Credit Suisse Index.2 And of note, this index has also spent nearly one-fifth of time at spreads sub-400bps over the past nearly three decades3 (see our blog “A Perspective on High Yield Spreads”).  So from a valuation perspective we do not see the high yield market as extreme, especially in the context of what is expected to be a low default environment (well below historical averages) for the next couple years.4

Additionally, we ultimately don’t see that the economic conditions are supportive of higher rates in the near to medium-term.  Data is open to interpretation, but the most recent data doesn’t seem to be indicating the strong Q2 recovery many in the stock market had hoped.  For instance, we’ve seen some disappointing retail sales of late and the housing market is showing some signs of cracks (weak housing starts).  Furthermore, yes, we are seeing the unemployment situation improve, but underneath the recently reported number is the reality that the job creation is coming from part time, low-wage work. There is still a large portion of working age people that are under-employed or that have given up looking for work all-together.

Above and beyond this, we see a long-term drag on rates coming from demographics, as the demand for fixed income products heat up (see our piece “Of Elephants and Rates”).  If anything, if you look at rates, those actually buying and selling bonds don’t seem to be getting the memo that rates will be rising soon, as the 10-year now sits at the lowest level that we have seen over the last 13 months.5  For evidence of this demand in Treasuries, look to the bid-to-cover ratio on all notes and bonds sold so far in 2014, which is over 3.0.  This means there was three times the demand as compared to issuance.  Additionally, keep in mind, just because the short-end of the curve might rise, that doesn’t necessarily mean the medium and longer end that corporate debt is more sensitive to will rise.  Ultimately these yields are determined by supply/demand, not necessarily Fed policy.

There has been a step back in the high yield market over the past couple weeks, nearly a 50 bps of spread-to-worst widening on the Band of America High Yield Index.6  We view that as healthy—no market should always, indiscriminately be going straight up.  We don’t believe that anything has fundamentally changed for this space or for the underlying companies, and we have even continued to see a well-functioning new issue market for high yield despite some of the pressure in the secondary high yield space.  While there could always be a surprise, we do not see any systemic shocks on the horizon.  There are certain areas that are of concern (such as the massive issuance of CLOs so far this year) but these areas are small and well contained.  So as we look at the current market, we would view these lower secondary prices for high yield bonds as a potential buying opportunity for secondary market players who are able to take advantage of them.

1 Source www.federalreserve.gov.
2 Current spread levels as of 7/17/14, based on the Credit Suisse High Yield Index, The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
3 Data sourced from Credit Suisse, as of 5/31/14.  Historical spread data covers the period from 1/31/1986 to 5/31/2014.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
4 For specific default projections sourced from J.P. Morgan, see our blog http://www.peritusasset.com/2014/06/a-perspective-on-high-yield-spreads/.
5 Current rate as of 7/17/14, based on the 10-year Constant Maturity Rate provided by the Federal Reserve.
6 Data sourced from Bloomberg, based on spread level of 353 as of 6/23/14 versus 399 as of 7/21/14 on the Bank of America High Yield index.  The Bank of America Merrill Lynch High Yield Index monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
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Peritus in the News

Peritus was mentioned in the following articles:

  • “Actively Managed ETFs Show Continued Growth,” by ETF Trends, July 16, 2014.
  • “Projecting Bond Total Returns For Rising Rates,” by Brad Kenagy, July 15, 2014.
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US Crude Exports Announcement

The recent announcement by the Department of Commerce Bureau of Industry and Security (BIS) regarding the approval of two applications to export limited quantities of field condensate, after undergoing minimal treatment by way of a stabilizer, is significant and should improve the profitability of the Eagle Ford region’s exploration and production (E&P) companies.

Condensates are a hydrocarbon associated with the production of oil and natural gas.  Because of its higher API gravity, a measure used to compare the relative densities of petroleum liquids, than medium or heavy crudes, condensates can be more easily converted into products such as gasoline for example. However, the drawback is that condensates have less energy content per barrel than medium and heavy crudes. These lighter crudes have accounted for a significant percentage of the surge in US crude production. According to a recent report by the EIA entitled, “U.S. Crude Oil Production Forecast—Analysis of Crude Type” published in May of this year, approximately 96% of the 1.8 million bbl/d growth in production between 2011 and 2013 consisted of these lighter crudes (specifically those  with API gravity of 40º or above).1

Condensates fall into two categories: field/lease condensate and plant condensate. Field condensate is condensate produced from oil wells and put through a field separator, where the liquids are separated from the gases such as methane. Plant condensate is produced from raw natural gas through a fractionating process or plant separator.

Until this week the export of plant condensate was legal, but field condensate was not. The challenge for E&Ps producing large volumes of field condensate is that most refineries are set up to handle a relatively narrow range of crudes, and are largely not able to process this product. Those that lack hydrotreater capacity for example can’t handle crudes above a certain sulphur content.  Likewise those refiners that that have invested in billions in infrastructure, such as crackers and cokers to handle heavy crudes, like those on the Gulf Coast, are not set up to handle lights or super light crudes.  The wave of super light crude out of the Eagle Ford, including these field condensates, has overwhelmed the existing refinery infrastructure. As a result, domestic condensates have traded at a discount at the Gulf Coast in comparison to other regions, such as Asia, or even Edmonton, Alberta for example, where condensates are in high demand as a diluent to enable the pipeline transport of bitumen from Alberta’s oil sands.

So prior to the approval of exporting field condensates, we were in essence left with a product for which there was only a marginal domestic market.  Producers were undergoing complicated processes to get around the arbitrary distinctions between plant and field condensate; however, the most recent announcement by the Department of Commerce should make the export of field condensate much simpler through the use of stabilizers. A stabilizer is the means by which an E&P prepares condensate to be transported by pipeline. This is the key part of the ruling by the Department of Commerce; it was a green light for exporting field condensate once undergoing this process.

All in all, it was a ruling that makes good sense.  Condensate is of limited use to the existing Gulf Coast refineries that are set up to handle heavier crudes. By enabling the export of these light hydrocarbons, producers will have the ability to access international markets and obtain higher realized prices, and markets that need this product will now have access to additional supply. This should alleviate some of the congestion in the North American midstream infrastructure and likely positively impact Light Louisiana Sweet prices that are currently competing for refining space on the Gulf Coast. The oil market is dynamic and ever evolving. Keeping abreast of new developments and their potential impact on current and potential holdings is a key link in the chain of Peritus’ active management strategy.

1 U.S. Energy Information Administration, “U.S Crude Oil Production Forecast—Analysis of Crude Types,” May 29, 2014, p. 2.
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The Opportunity in Unconventional Oil

Be it energy geopolitics or pipeline politicking, oil markets are clouded by noise that push prices up and down. In order to make long-term investments in the space the trick is to boil it down to the bare bones of the issue. Recently an article was published espousing that oil was headed to $75. It was an interesting notion but not one we would put much stock in for a variety of reasons, the most basic of which being supply.

Conventional production (a category that includes onshore and offshore crude oil, natural gas and condensates produced by way of traditional vertical drilling methods) around the globe is in decline. Unconventional production is the primary source of new production coming to market today. Those unconventional sources fall into three broad categories. Shale oil, oil sands and ultra deepwater. Offshore, ultra-deep is pretty self-explanatory: it’s deep and expensive. The onshore complications, though, seem to get glossed over or forgotten so let’s review them.

Shale oil extraction is accomplished by way of horizontal drilling and fracking the source rock (shale). In lay person terms it is basically this: you drill a hole a couple of miles deep then steer the drillbit 90º and drill sideways another couple of miles. As if that weren’t enough trouble to go through to get a return, now you remove the drill, case the well and set to the process of breaking up the rock in a series stages by way of perforations. Once the “micro fissures” are created, you have to keep them open and encourage the oil to flow, so water, sand and often a myriad of other chemicals are pumped into the cracks. As you can imagine this is not a cheap process. What makes it more challenging though is that the decline rates—how quickly the oil flowing from the well peters out—are very high (we estimate 80-90% in the first three years so). As a result, you have to keep drilling at a very high rate just to maintain production levels.

Canada’s oil sands are the other key source of unconventional production. They are located in Northern Alberta where temperatures in the winter can routinely reach -40º Fahrenheit and in the summer the bugs are so bad small children can be carried away. 20% of the oil from the oil sands is minable (those are the nasty pictures you always see when anyone mentions the oil sands, or tar sands as they are affectionately referred to). The other 80% is too deep to mine and are thus only producible by way of in-situ thermal production.1 The most common thermal production method is called Steam Assisted Gravity Drainage or SAGD.

SAGD entails drilling two horizontal wells one directly above the other, called well pairs. The top well pair, called the injector well, injects stream, heated by natural gas. The bottom well pair is called the producer well and brings the water and bitumen to the surface. Numerous well pairs are required per reservoir. The time from first stream to production can be anywhere from 18-24 months. Once heated sufficiently the bitumen, which has the consistency of a hockey puck at room temperature, turns into a viscous sludge that by way of gravity falls downwards to the producer well at the bottom. From there the producer well pumps the sludge to the surface were it is mixed with condensates/superlight oils to be transported to market. By our estimates, based on conversations with industry professionals, the costs associated with building one of these facilities is about $50,000 per flowing barrel. So that means if you want to build a 20,000 barrel per day facility you need a billion dollars and then wait two years for any type of return.

We’re not peak oil theorists, but realists. If oil were plentiful nobody would care about shale oil, oil sands or ultra deepwater plays. They would be considered marginal barrels in a well-supplied market and would never get produced due to the lower prices that would accompany such an environment. That however is not the world we live in, and looking forward these barrels are the primary sources of new production coming to market.

When one looks at where oil is headed common sense tells us that it won’t be below the cost plus a decent rate of return that is required to bring these sources of oil to market. Ultimately, as we rely more and more on this unconventional production, we see high oil prices as here to stay and investors need to invest accordingly.

But just where do you invest?  Are all of these oil producing regions making for attractive investments?  We argue no.  We believe that the Western Canadian Sedimentary Basin (Canadian oilsands) has a much different and more sustainable production profile than most shale basins in the US.  We do not see the shale “revolution” as anything of the sort; rather, current production and growth in this area is unsustainable.  The decline rates on these wells are extreme, meaning more and more holes will need to be punched to keep production flat.  A look at the U.S.-based crude growth numbers and expectations shows that the massive growth we have seen is expected to peter out over the next several years.2

Blog 7-15-14

Source: U.S. Energy Information Administration, data as of January 13, 2014.

With the easiest oil produced first, the marginal cost of a new barrel of production will likely continue to increase.  Above and beyond the rapid decline rates, we see other challenges to shale production, including that this is a water intensive process, yet we are seeing droughts in the Midwest and West, and legislation on the safety of fracking and the transportation of product is likely to get more severe.

Unconventional resources have become conventional.  The overall quality and access to some of these “new conventional” energy reserves is declining, increasing costs for producers and we expect to ultimately keep prices elevated.  We believe that investors should be long and strong this industry to take advantage of the sustained higher prices.  However, selectivity is warranted. Investors should avoid what we believe is the next CLEC-Telco disasters of 2002-03, which is the high yield market financing of many unsustainable business models known as shale/tight oil production.  Here we have seen incredible popularity, with deal after deal getting done, regardless of quality, and many done at very low yields, which we feel do not compensate investors for the risk of the lack of cash flow generation and sustainability of some of these businesses.

We also believe that investors should be cautious in Master Limited Partnership (“MLP”) investing.  Investors have been enticed by the juicy yields offered, but unfortunately many of them are not generating true distributable cash.  Worse yet, “cash available for distribution” is a metric that the company themselves calculate.  This is a situation of the fox guarding the hen house.  This metric is calculated by breaking up capital expenditures into “maintenance” and “growth.”  So the more the company lumps their capital expenditures into the “growth” bucket, the more fictional cash flow they have available.  Some of the companies we have looked at state that 80% of their capital expenditures are “growth,” yet they aren’t growing.  For investors this then is a return of capital not a return on capital and we believe is unsustainable.

We have seen a recent pull back in the price of oil and believe it creates an opportunity to continue to invest in oil producers.  Our take remains that supply from US tight oil/shale is real but temporary and that many of the swing producers will continue to struggle to meet their production targets.  As examples, look to Libya, Iraq, Venezuela and Nigeria.  We continue to invest up and down the capital structures (loans, bonds and yield equities) of what we view are very sustainable producers to find what we see as the optimal risk/return characteristics.

1 Source: Wikipedia, Athabasca oil sands, http://en.m.wikipedia.org/wiki/Athabasca_oil_sands.
2 Source: U.S. Energy Information Administration, data as of January 13, 2014.

 

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Peritus in the News

Peritus was mentioned in the article, “Fundamental Bond ETFs Prove Tough to Tackle” by Brendan Conway of Barron’s, July 12, 2014.

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Peritus in the News

Ron Heller of Peritus was quoted in the article, “Fixed-Income Trading Gets a Bit More Electrifying” by Trang Ho of Institutional Investor, July 11, 2014.

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High Yield versus Equities

Investors are often led down the path that they must invest in equities in order to generate a decent return, and that the high yield market is too risky and speculative.  However, reality and the data points prove otherwise.  Looking over the past couple decades and various periods in between, you can see that high yield has consistently outperformed the equity market (as measured by the S&P 500 Index) on a risk adjusted basis (return/risk).1

Blog 7-10-14

Here, risk is defined as standard deviation, or volatility of returns.  What is even more notable is that the high yield market outperformed equities over the 10- and 15-year periods on a pure return basis, even without adjusting for the fact that the high yield market carries less risk.  Even taking into account the enormous technology and internet rallies of the late 1990’s, high yield bonds have performed only slightly lower than equities over the past 25 years, but with about 40% less risk (standard deviation).

Looking at that “riskiness” of the high yield asset class in another way, investors need to remember that in a company’s capital structure, equities fall below bonds, no matter the bond rating (investment grade or high yield).  This means that in any sort of difficult situation, the bonds get paid back first.  Further, as the data above shows, high yield bonds have much lower risk as measured by volatility (annualized standard deviation), giving high yield bonds what we see as a significant return/risk advantage.

The data speaks for itself: it seems to be time for investors to reconsider their sizable allocations to the equity market and instead, consider an increased allocation to the high yield bond market.  And with the advent of high yield exchange traded funds, accessing the high yield market is now available to retail and institutional investors alike.

Credit Suisse High Yield Index is an index designed to mirror the investible universe of the $US-denominated high yield debt markets.  Credit Suisse High Yield Index data sourced from Credit Suisse. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks.  S&P 500 index data sourced from Bloomberg, using a total return including dividend reinvestment. Annualized Total Return and Standard Deviation calculations are based on monthly returns.  Return/Risk calculated as the Annualized Total Return divided by Annualized Standard Deviation.

 

 

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Peritus in the News

Tim Gramatovich of Peritus was interviewed for the article “High Debt Loads Threatening Many Smaller Oil Companies With Bankruptcy,” by Andrew Schneider of Houston Public Media, July 7, 2014.

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Peritus in the News

Peritus was mentioned in the article “Fill Out Your Investment Portfolio with ETFs” on ETF Trends, July 1, 2014.

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Peritus in the News

Peritus was mentioned in the article, “Active Management: The Next Frontier of ETF Growth,” by ETF Trends, June 25, 2014.

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